Corporate defaults mean more hedge fund blow-ups

As the economy hits stall speed, it is only to be expected that corporate default rates are set to rise. In fact, they have risen already, doubling since 2007.

Through last week, 42 companies, all but one based in the U.S., have defaulted, affecting $33.6 billion worth of debt, according to rating agency Standard & Poor’s.

That compares to 16 U.S. defaults last year and 22 in 2006.

“Companies have been under pressure with the weakening economic growth and unfolding recessionary conditions,” said Diane Vazza, head of Standard & Poor’s global fixed-income research group.

“We’re seeing banks tightening lending standards which means that it was much more difficult, if not impossible, to get credit or tap the capital market for companies with the most urgent needs. When sales and profits are slow, they get squeezed,” she said.

Among companies that have defaulted this year are casino operator Tropicana Entertainment, home product-retailer Linens ‘n Things and GMAC LLC mortgage subsidiary Residential Capital.

Default rate doubles

The rate of default among speculative-grade debt, rated BB-plus or lower by S&P, rose in June to 1.92%, up for a sixth month and from a 25-year low of 0.97% in 2007.

Martin Fridson, chief executive of Fridson Investment Advisors, said in a note to clients that he believed this trade [known as a carry trade between treasurys and high-yield] has forced up risk premiums on the riskiest junk bonds to dangerously inflated levels, a trend which could unwind quickly as corporate default rates rise, potentially provoking deep losses in the hedge fund sector.

The chief risk in such a trade comes from the higher vulnerability of high-yield bonds to default, when the company cannot make its repayments. In recent years this has been a risk hedge funds have been willing to live with, particularly given the benign credit environment, which has in turn sustained default rates at cyclical lows.

The trades have recently widened the spreads on the riskiest bonds further when compared with spreads on less risky bonds, according to FIA.

FIA said less risky high-yield bonds rated BB and B are trading with an option-adjusted spread of 675 basis points over Treasuries compared to a historical average of 428 basis points. By contrast, FIA said the spread on the riskiest high-yield bonds rated CCC is trading at 1,199 basis points compared to historical average of 1,164 basis points.

Fridson said: “[Hedge funds] sole criterion for buying CCC bonds was that the yield exceeded their cost of funds. The resulting interest rate differential was small, but by leveraging their portfolios these buyers achieved their targeted returns. Unfortunately, they will probably give back their profits and more as the recent escalation in default rates continues.”–Financial News Online, 9 Jul 2008

To date, hedge funds have stayed out of the limelight as the financials have imploded. The rise in defaults may change that.

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty five years of business experience. He has also been a regular economic and financial commentator in print and on television for the past decade. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College.